Why is the ECB Being so Gradualist?

Jim Surowiecki asks a good question today: if you know that you’re going to cut interest rates — and Jean-Claude Trichet has made it abundantly clear that he intends to cut interest rates in March — why not do so now?

Surowiecki thinks that the ECB’s inaction on Thursday is further evidency that it’s doing "a terrible job"; I wouldn’t go nearly that far. And I think there are a few reasons why the ECB’s relatively gradualist approach is defensible.

First, it’s not really true that people won’t take out loans today because they think rates will be lower next month. Loans, remember, are either fixed-rate or floating-rate; most corporate loans are floating-rate. So if you think rates will be lower next month, you’ll be more likely to take out a floating-rate loan today than if you didn’t think that. Meanwhile, if you take out a fixed-rate loan, there’s no reason at all that a half-point cut next month — which is already fully priced in to the market — is going to show up in lower interest rates than prevail today.

More generally, while Surowiecki is right that "monetary policy takes time to work", expected interest rates are at least as important as the interest rates themselves. Trichet might have been moving slowly during this crisis, at least by US standards, but he’s been good at signalling: he follows through on his promises, and doesn’t panic.

In turn, that means that there’s much less uncertainty over European interest rates than there is over US rates — and the markets hate nothing more than uncertainty.

Why do central banks have tightening and loosening cycles? Why don’t they just set interest rates at exactly the level they think that rates should be set at, and leave it at that until they change their mind? If they did that, rates would move up and down quite frequently — but instead we commonly find very long periods of relatively small rate increases, and equally long periods of rate decreases.

The result is that interest rates become smoother and more predictable, which the markets love. And what’s more, central banks get to announce lots of rate cuts or rate hikes, rather than just one big one — and a series of interest-rate announcements, all pointing in the same direction, is a powerful thing when it comes to those all-important expectations.

Now it’s still arguable that Trichet has been behind the curve during this crisis — in fact, if the curve is being set by Bernanke, it’s absolutely certain. Maybe it’s true that exceptional times call for exceptional central bank actions, and Trichet is too hidebound to go there. But in general, holding rates steady one month while signalling a rate cut in a month’s time is not prima facie evidence that a central banker has no idea what he’s doing.